Fastest- and Slowest-Growing Economies During 1980–2000
and Their Status of Financial Openness

3.2.

Summary of Recent Research on Financial Integration and
Economic Growth

4.1.

Volatility of Annual Growth Rates of Selected Variables

Appendix Tables

A2.1.

Non-OECD Countries: Gains from International Financial Integration

A3.1.

Summary of Studies on Welfare Gains from International Risk
Sharing

A5.1.

Are Small States Different? Some Summary Statistics, 1960–2000

I. Overview

The recent wave of financial globalization that has occurred since the
mid-1980s has been marked by a surge in capital flows among industrial
countries and, more notably, between industrial and developing countries.
Although capital inflows have been associated with high growth rates
in some developing countries, a number of them have also experienced
periodic collapses in growth rates and significant financial crises that
have had substantial macroeconomic and social costs. As a result, an
intense debate has emerged in both academic and policy circles on the
effects of financial integration on developing economies. But much of
the debate has been based on only casual and limited empirical evidence.

The main purpose of this paper is to provide an assessment of empirical
evidence on the effects of financial globalization for developing economies.
It will focus on three related questions:

(ii) What is its impact on macroeconomic volatility in these countries?;
and

(iii) What are the factors that appear to help countries obtain the
benefits of financial globalization?

The principal conclusions that emerge from the analysis are sobering
but, in many ways, informative from a policy perspective. It is true
that many developing economies with a high degree of financial integration
have also experienced higher growth rates. It is also true that, in theory,
there are many channels through which financial openness could enhance
growth. A systematic examination of the evidence, however, suggests that
it is difficult to establish a robust causal relationship between the
degree of financial integration and output growth performance. From the
perspective of macroeconomic stability, consumption is regarded as a
better measure of well-being than output; fluctuations in consumption
are therefore regarded as having negative impacts on economic welfare.
There is little evidence that financial integration has helped developing
countries to better stabilize fluctuations in consumption growth, notwithstanding
the theoretically large benefits that could accrue to developing countries
if such stabilization were achieved. In fact, new evidence presented
in this paper suggests that low to moderate levels of financial integration
may have made some countries subject to greater volatility of consumption
relative to that of output. Thus, while there is no proof in the data
that financial globalization has benefited growth, there is evidence
that some countries may have experienced greater consumption volatility
as a result.

Although the main objective of this paper is to offer empirical evidence,
and not to derive a set of definitive policy implications, some general
principles nevertheless emerge from the analysis about how countries
can increase the benefits from, and control the risks of, globalization.
In particular, the quality of domestic institutions appears to play a
role. A growing body of evidence suggests that it has a quantitatively
important impact on a country's ability to attract foreign direct investment
and on its vulnerability to crises. Although different measures of institutional
quality are no doubt correlated, there is accumulating evidence of the
benefits of robust legal and supervisory frameworks, low levels of corruption,
a high degree of transparency, and good corporate governance.

A review of the available evidence does not, however, provide a clear
road map for countries that have either started on or desire to start
on the path to financial integration. For instance, there is an unresolved
tension between having good institutions in place before capital market
liberalization and the notion that such liberalization in itself can
help a country import best practices and provide an impetus to improve
domestic institutions. Furthermore, neither theory nor empirical evidence
has provided clear-cut general answers to related issues, such as the
desirability and efficacy of selective capital controls. Ultimately,
these questions can be addressed only in the context of country-specific
circumstances and institutional features.

The remainder of this section provides an overview of the structure
of this paper. Section II documents some salient features of global financial
integration from the perspective of developing countries. Sections III
and IV analyze the evidence on the effects of financial globalization
on growth and volatility, respectively, in developing countries. Section
V discusses the relationship between the quality of institutions and
the benefit-risk trade-off involved in undertaking financial integration.

Definitions and Basic Stylized Facts

Financial globalization and financial integration are, in principle,
different concepts. Financial globalization is an aggregate concept that
refers to increasing global linkages created through cross-
border financial flows. Financial integration refers to an individual country's
linkages to international capital markets. Clearly, these concepts are closely
related. For instance, increasing financial globalization is perforce associated
with increasing financial integration on average. In this paper, therefore,
the two terms are used interchangeably.

Of more relevance for the purposes of this paper is the distinction
between de jure financial integration, which is associated with policies
on capital account liberalization, and actual capital flows. For example,
indicator measures of the extent of government restrictions on capital
flows across national borders have been used extensively in the literature.
On the one hand, using this measure, many countries in Latin America
would be considered closed to financial flows. On the other hand, the
volume of capital actually crossing the borders of these countries has
been large relative to the average volume of such flows for all developing
countries. Therefore, on a de facto basis, these Latin American countries
are quite open to global financial flows. By contrast, some countries
in Africa have few formal restrictions on capital account transactions
but have not experienced significant capital flows. The analysis in this
paper will focus largely on de facto measures of financial integration,
as it is virtually impossible to compare the efficacy of various complex
restrictions across countries. In the end, what matters most is the actual
degree of openness. However, the paper will also consider the relationship
between de jure and de facto measures.

A few salient features of global capital flows are relevant to the central
themes of the paper. First, the volume of cross-border capital flows
has risen substantially in the last decade. There has been not only a
much greater volume of flows among industrial countries but also a surge
in flows from industrial to developing countries. Second, this surge
in international capital flows to developing countries is the outcome
of both "pull" and "push" factors. Pull factors arise from changes in
policies and other aspects of opening up by developing countries. These
include liberalization of capital accounts and domestic stock markets,
and large-scale privatization programs. Push factors include business-cycle
conditions and macroeconomic policy changes in industrial countries.
From a longer-term perspective, this latter set of factors includes the
rise in the importance of institutional investors in industrial countries
and demographic changes (for example, the relative aging of the population
in industrial countries). The importance of these factors suggests that
notwithstanding temporary interruptions during crisis periods or global
business-cycle downturns, the past twenty years have been characterized
by secular pressures for rising global capital flows to the developing
world.

Another important feature of international capital flows is that the
components of these flows differ markedly in terms of volatility. In
particular, bank borrowing and portfolio flows are substantially more
volatile than foreign direct investment. Although accurate classification
of capital flows is not easy, evidence suggests that the composition
of capital flows can have a significant influence on a country's vulnerability
to financial crises.

Does Financial Globalization Promote Growth in Developing Countries?

This subsection of the paper will summarize the theoretical benefits
of financial globalization for economic growth and then review the empirical
evidence. Financial globalization could, in principle, help to raise
the growth rate in developing countries through a number of channels.
Some of these directly affect the determinants of economic growth (augmentation
of domestic savings, reduction in the cost of capital, transfer of technology
from advanced to developing countries, and development of domestic financial
sectors). Indirect channels, which in some cases could be even more important
than the direct ones, include increased production specialization owing
to better risk management, and improvements in both macroeconomic policies
and institutions induced by the competitive pressures or the "discipline
effect" of globalization.

How much of the advertised benefits for economic growth have actually
materialized in the developing world? As documented in this paper, average
per capita income for the group of more financially open (developing)
economies grows at a more favorable rate than that of the group of less
financially open economies. Whether this actually reflects a causal relationship
and whether this correlation is robust to controlling for other factors,
however, remain unresolved questions. The literature on this subject,
voluminous as it is, does not present conclusive evidence. A few papers
find a positive effect of financial integration on growth. The majority,
however, find either no effect or, at best, a mixed effect. Thus, an
objective reading of the results of the vast research effort undertaken
to date suggests that there is no strong, robust, and uniform support
for the theoretical argument that financial globalization per se delivers
a higher rate of economic growth.

Perhaps this is not surprising. As noted by several authors, most of
the cross-country differences in per capita incomes stem not from differences
in the capital-labor ratio but from differences in total factor productivity,
which could be explained by "soft" factors such as governance and the
rule of law. In this case, although embracing financial globalization
may result in higher capital inflows, it is unlikely, by itself, to cause
faster growth. In addition, as is discussed more extensively later in
this paper, some of the countries with capital account liberalization
have experienced output collapses related to costly banking or currency
crises. An alternative possibility, as noted earlier, is that financial
globalization fosters better institutions and domestic policies but that
these indirect channels can not be captured in standard regression frameworks.

In short, although financial globalization can, in theory, help to promote
economic growth through various channels, there is as yet no robust empirical
evidence that this causal relationship is quantitatively very important.
This points to an interesting contrast between financial openness and
trade openness, since an overwhelming majority of research papers have
found that the latter has had a positive effect on economic growth.

What Is the Impact of Financial Globalization on Macroeconomic Volatility?

In theory, financial globalization can help developing countries to
better manage output and consumption volatility. Indeed, a variety of
theories imply that the volatility of consumption relative to that of
output should decrease as the degree of financial integration increases;
the essence of global financial diversification is that a country is
able to shift some of its income risk to world markets. Since most developing
countries are rather specialized in their output and factor endowment
structures, they can, in theory, obtain even bigger gains than developed
countries through international consumption risk sharing—that is,
by effectively selling off a stake in their domestic output in return
for a stake in global output.

How much of the potential benefits, in terms of better management of
consumption volatility, has actually been realized? This question is
particularly relevant in terms of understanding whether, despite the
output volatility experienced by developing countries that have undergone
financial crises, financial integration has protected them from consumption
volatility. New research presented in this paper paints a troubling picture.
Specifically, although the volatility of output growth has, on average,
declined in the 1990s relative to the three preceding decades, the volatility
of consumption growth relative to that of income growth has, on average, increased for
the emerging market economies in the 1990s, which was precisely the period
of a rapid increase in financial globalization. In other words, as is
argued in more detail later in the paper, procyclical access to international
capital markets appears to have had a perverse effect on the relative
volatility of consumption for financially integrated developing economies.

Interestingly, a more nuanced look at the data suggests the possible
presence of a threshold effect. At low levels of financial integration,
an increment in the level of financial integration is associated with
an increase in the relative volatility of consumption. Once the level
of financial integration crosses a threshold, however, the association
becomes negative. In other words, for countries that are sufficiently
open financially, relative consumption volatility starts to decline.
This finding is potentially consistent with the view that international
financial integration can help to promote domestic financial sector development,
which, in turn, can help to moderate domestic macroeconomic volatility.
Thus far, however, these benefits of financial integration appear to
have accrued primarily to industrial countries.

In this vein, the proliferation of financial and currency crises among
developing economies is often viewed as a natural consequence of the "growing
pains" associated with financial globalization. The latter can take various
forms. First, international investors have a tendency to engage in momentum
trading and herding, which can be destabilizing for developing economies.
Second, international investors may (together with domestic residents)
engage in speculative attacks on developing countries' currencies, thereby
causing instability that is not warranted based on their economic and
policy fundamentals. Third, the risk of contagion presents a major threat
to otherwise healthy countries, since international investors could withdraw
capital from these countries for reasons unrelated to domestic factors.
Fourth, a government, even if it is democratically elected, may not give
sufficient weight to the interest of future generations. This becomes
a problem when the interests of future and current generations diverge,
causing the government to incur excessive amounts of debt. Financial
globalization, by making it easier for governments to incur debt, might
aggravate this "overborrowing" problem. These four hypotheses are not
necessarily independent and can reinforce each other.

There is some empirical support for these hypothesized effects. For
example, there is evidence that international investors do engage in
more herding and momentum trading in emerging markets than in developed
countries. Recent research also suggests the presence of contagion in
international financial markets. In addition, some developing countries
that open their capital markets appear to accumulate unsustainably high
levels of external debt.

To summarize, one of the theoretical benefits of financial globalization,
other than enhancing growth, is allowing developing countries to better
manage macroeconomic volatility, especially by reducing consumption volatility
relative to output volatility. The evidence suggests, instead, that countries
in the early stages of financial integration have been exposed to significant
risks in terms of higher volatility of both output and consumption.

Role of Institutions and Governance in Effects of Globalization

Although it is difficult to find a simple relationship between financial
globalization and growth or consumption volatility, there is some evidence
of nonlinearities or threshold effects in the relationship. Financial
globalization, in combination with good macroeconomic policies and good
domestic governance, appears to be conducive to growth. For example,
countries with good human capital and governance tend to do better at
attracting foreign direct investment (FDI), which is especially conducive
to growth. More specifically, recent research shows that corruption has
a strongly negative effect on FDI inflows. Similarly, transparency of
government operations, which is another dimension of good governance,
has a strong positive effect on investment inflows from international
mutual funds.

The vulnerability of a developing country to the risk factors associated
with financial globalization is also not independent of the quality of
macroeconomic policies and domestic governance. For example, research
has demonstrated that an overvalued exchange rate and an overextended
domestic lending boom often precede a currency crisis. In addition, lack
of transparency has been shown to be associated with more herding behavior
by international investors, which can destabilize a developing country's
financial markets. Finally, evidence shows that a high degree of corruption
may affect the composition of a country's capital inflows, thereby making
it more vulnerable to the risks of speculative attacks and contagion
effects.

Thus, the ability of a developing country to derive benefits from financial
globalization and its relative vulnerability to the volatility of international
capital flows can be significantly affected by the quality of both its
macroeconomic framework and its institutions.

Summary

The objective of the paper is not so much to derive new policy propositions
as it is to inform the debate on the potential and actual benefit-risk
trade-offs associated with financial globalization by reviewing the available
empirical evidence and country experiences. The main conclusions are
that, so far, it has proven difficult to find robust evidence supporting
the proposition that financial integration helps developing countries
to improve growth rates and reduce macroeconomic volatility.

Of course, the absence of robust evidence on these dimensions does not
necessarily mean that financial globalization has no benefits and carries
only great risks. Indeed, most countries that have initiated financial
integration have continued along this path despite temporary setbacks.
This observation is consistent with the notion that the indirect benefits
of financial integration, which may be difficult to pick up in regression
analysis, could be quite important. Also, the long-run gains, which in
some cases have not yet been realized, may exceed the short-term costs.
For instance, although Europe's efforts to achieve monetary integration
resulted in its being buffeted by severe and costly crises in the early
1990s, these efforts eventually brought about the transition to the single
currency in use throughout much of Europe today.

Although it is difficult to distill new and innovative policy messages
from the review of the evidence, there appears to be empirical support
for some general propositions. Empirically, good institutions and quality
of governance are important not only in their own right but also in helping
developing countries derive the benefits of globalization. Similarly,
macroeconomic stability appears to be an important prerequisite for ensuring
that financial integration is beneficial for developing countries. In
this regard, the IMF work in promulgating standards and codes for best
practices on transparency and financial supervision, as well as sound
macroeconomic frameworks, is crucial. These points may already be generally
accepted; the contribution of this paper is to show that there is some
systematic empirical evidence to support them. In addition, the analysis
suggests that financial globalization should be approached cautiously
and with good institutions and macroeconomic frameworks viewed as preconditions.

This paper does not tackle the appropriate choice of an exchange rate
regime or of monetary and fiscal policies. It is worth noting, however,
that fixed or de facto fixed exchange rate regimes and excessive government
borrowing appear to be major factors that have compounded the problems
that some developing countries have had in managing capital flows. We
leave a systematic examination of these issues for future research.